Investment-Grade Corporates: A Bridge Between Equities and Bonds

David BradinInvestment SpecialistLos Angeles office 10 years of experience

Investment-Grade Corporates: A Bridge Between Equities and Bonds

Key Takeaways

High-quality corporate bonds are a core bond strategy

They can provide more income than government-backed bonds

Research-driven corporate bond funds have advantages

In the recent market rally that has been characterized by a risk-on sentiment across most asset classes, investors have gravitated to high yield and leveraged bank loans or income strategies with a heavy allocation to these extended sectors of the market. As we approach the late stages of this market rally, we think it is appropriate for investors to take a fresh look at their credit exposure.

The Role of Corporate Bonds in a Portfolio

We believe that investment-grade corporate bonds provide an attractive risk-return trade-off as a core bond fund allocation. On a long-term, secular basis, prudently managed corporate bond funds can play an important role in portfolios. Corporate bonds have historically provided income, diversification from equity holdings, as well as principal preservation.

The relationship between return and volatility can be illustrated through an efficient frontier chart. Although investors can tack on higher average returns with asset classes like high yield or emerging markets, these bonds make for poor portfolio stabilizers when economic shocks hit.

Efficient Frontier 5-year standard deviation

Source: RIMES. As of 7/31/2017.

This chart uses indices to show that investors looking purely for stability could do even better with core bond funds that focus on government bonds like Treasuries. However, these strategies provide weaker returns than well-run investment-grade corporate bond funds. Although investors do sacrifice some stability to achieve higher returns through IG corporates, the group still exhibits a relatively low standard deviation compared to other higher yielding asset classes.

Lower Correlation Than High-Yield Bonds High-yield bonds had a correlation of 0.65 to the S&P 500 Index over the past five years, while investment-grade bonds had a correlation of just 0.14.

Source: Bloomberg Investment Services Ltd. As of 6/30/2017.

The Research Advantage

U.S. investment-grade corporate bonds are historically an under-researched asset class. This provides an opportunity for managers like Capital Group who use deep fundamental research. The IG corporate market has matured and become much more liquid, with a market capitalization of $5 trillion and over 1,000 issuers. This allows investors to build well-rounded, diversified corporate bond portfolios.

But that is highly dependent on strong credit selection. While credit quality is high across the asset class, a dispersion of returns occurs across issuers, sectors and ratings. Managers assessing individual securities can take advantage of this dispersion to identify the most attractive investment opportunities on a risk-adjusted basis.

Passive Pitfalls

In contrast, since fixed income indices are market-value based, the most indebted issuers within each asset class are the most heavily weighted issuers. Thus, relying on passive index-based strategies means that investors are more exposed to the market’s most indebted issuers. Managers assessing individual issuers can avoid this passive pitfall by investing in debt that provides adequate risk-based returns based on issuers’ capital structures, and can capitalize on relative value opportunities they identify in the market.

Passive strategies also require new issuance to be included in the index, while managers can invest selectively based upon an issuer’s merits. Passive index-based strategies must rebalance based upon changes in market valuations, potentially requiring buying when prices are high or selling when prices are low; in contrast, managers who rely on research, buy and sell based on relative value.

Higher Returns Than Government-Driven Core Bonds Investment-grade corporate bonds provided an annualized return of 5.7% over the past 15 years, while core bonds returned just 4.5%.

Source: Bloomberg Investment Services Ltd. As of 6/30/2017.

U.S. IG bonds are a core asset class, providing income, diversification from equity and principal preservation. Long-term investors to the asset class have the potential to receive higher income than a government bond-driven core fund, and are less exposed to volatility than they would be in a high-yield focused multisector bond fund. An allocation to an IG corporate bond fund can improve the risk and return profiles of investors’ broader investment portfolios.

Growth of U.S. Investment-Grade Corporate Market

Source: Bloomberg Index Services Ltd. As of 7/31/2017.

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Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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